Diverging Interest Rates Mask a Convergence in Inflation Expectations
Despite global nominal interest rates converging around zero in early 2020 – with the US falling under 1% and the EU briefly turning negative – a closer look reveals a more nuanced picture. Central banks initially coordinated to inject liquidity into the global economy, but as monetary policies have sence diverged, so too have interest rates. Though, this divergence in nominal rates obscures a key trend: a growing convergence in inflation expectations across major economies.
The initial response to the economic pressures of 2020 saw “the monetary spigots were on, and central banks coordinated to squirt liquidity everywhere they could,” according to one analyst. Since then,the landscape has shifted,with Japanese rates remaining notably lower than those in other developed countries. But the real story lies beneath the surface.
Nominal rates, as one senior official stated, are “approximately the sum of real rates – the cost of money – and compensation for expected inflation.” Utilizing data from the swaps market and inflation-indexed bond market, economists can dissect nominal rates into these two crucial components, revealing starkly different narratives depending on the country.
the analysis focuses on the US, EU, japan, and the UK, with the UK’s well-established inflation-linked bond market making it a particularly insightful case study. In 2020, the UK exhibited the highest implied inflation and the lowest real rates within this group. This was largely driven by “pension fund demand caused long-term linkers to be outrageously expensive,” as one market observer noted. Conversely, Japan, facing persistent near-deflation, had the lowest implied inflation and the highest real rates. Interestingly, despite similar 10-year nominal rates, the composition of those rates differed dramatically between the UK and Japan. “
Currently,inflation expectations are converging towards roughly 2.5%, aligning with the US rate after adjusting for variations in index composition. However, the cost of money itself isn’t following suit. Real rates are gradually increasing across many economies, suggesting strengthening long-term equilibrium growth expectations. The US is currently leading this trend, with Japan lagging behind.
The UK’s real rate has recently surpassed that of the EU, a development that seems logical given the current economic challenges facing Europe. While these shifts don’t appear to have immediate implications for “hot money trading,” understanding the underlying dynamics is crucial.
As one analyst pointed out,it’s becoming increasingly clear that differences in nominal rates are driven more by variations in real rates than by differing expectations of inflation. Furthermore, the global average cost of money is rising, a trend that could eventually create headwinds for other asset classes.
While acknowledging that differences in inflation definitions and index usage exist – and will likely pers
Here’s a breakdown answering the “Why,Who,What,and How” questions,turning the update into a substantive news report:
Why: The report examines the divergence between nominal interest rates and the convergence of inflation expectations across major economies (US,EU,Japan,UK). It aims to explain the underlying economic forces driving these trends and their potential implications.
Who: The analysis is based on insights from economists,central bank officials,and market observers. The focus is on the monetary policies of central banks in the US, EU, Japan, and the UK, and how these policies impact real rates and inflation expectations.
What: The core finding is that while nominal interest rates are diverging, inflation expectations are converging around 2.5%. This divergence is primarily driven by changes in real interest rates (the cost of money) rather than differing inflation expectations. The US is leading the trend of rising real rates, while Japan is lagging.
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